In July 2013, the Knesset legislated major changes to the Israeli tax regime (Income Tax Ordinance Amendment 197).
Nearly two years later, the Israeli Tax Authority (ITA) issued a Circular which clarifies certain aspects of the Amendment (Supplement 1 to Circular 1/2010, dated March 10, 2015).
Amendment 197 seeks to impose Israeli tax on most trusts with an Israeli resident beneficiary, commencing January 1, 2014. Also, trust distributions received by Israeli residents on or after August 1, 2013 generally must be notified to the ITA.
Foreign Residents’ Trust Clarification:
The Circular states that a tax-privileged Foreign Residents’ Trust is a trust which satisfies one of the following:
- In the tax year all the settlors (=grantors) and all the beneficiaries are foreign residents, OR all the settlors are foreign residents and all the beneficiaries are public benefit beneficiaries (mainly Israeli charities) or foreign residents, and there were no Israeli resident beneficiaries since their formation;
- A trust in which all the settlors are deceased and all the beneficiaries in the tax year are foreign residents, OR all the settlors are deceased and all the beneficiaries are public benefit beneficiaries (mainly Israeli charities) or foreign residents, and there were no Israeli resident beneficiaries since their formation;
The Circular stresses the trust will be liable to Israeli tax from 2014 if the settlor is a foreign resident or was upon his death and there is, or was in the past, an Israeli resident beneficiary.
Note: This would rule out the strategy of removing Israeli residents from the list of beneficiaries.
Testamentary Trust Advantage
In the case of a taxable Israeli Residents Trust in which all the beneficiaries are foreign residents, if the last Israeli resident settlor dies, the trust will become a tax privileged Foreign Testamentary Trust.
Note: The trust assets will be regarded as passing upon death as a tax-exempt legacy, not as a taxable sale, according to the Circular. This seems favorable, but the position in other relevant countries should also be checked.
Relatives’ Trust – Reporting Deadline Looming
A Relatives’ Trust is an Israeli Resident Beneficiary Trust in which all the settlors and all the beneficiaries are related individuals, as defined in detail in the law.
Note: This is intended to deter professionals setting up trusts, foundations or establishments for the benefit of unrelated Israeli residents.
An Israeli Resident Beneficiary Trust, is a trust in which the settlors were foreign residents since formation of the trust, but there is at least one Israeli resident beneficiary in the tax year.
In general, a Relatives’ Trust must be notified by the Trustee to the ITA within 60 days after it was formed or became such a trust on Tax Forms 147 and 154.
A pre-2014 Relatives’ trust must be notified to the ITA by June 30, 2015 or any later date allowed by the ITA for filing the 2014 tax return, but not beyond December 31, 2015.
Form 154 also requires an irrevocable choice to be made between:
- The Distributions Track: Israeli tax of 30% on foreign source income and gains if and when it is distributed. Note: The recipient beneficiary must file an annual tax return and report the distribution received on Tax Form 149, even if a tax return isn’t otherwise needed from that beneficiary (but see below for Olim).
- The Allocated Income Track: Israeli tax of 25% on income derived abroad and attributed to Israeli resident beneficiary, in the year it is derived.
If no choice is made, the Distributions Track will apply. Israeli source income, if any, is taxed at regular Israeli rates.
Neither the law nor the Circular clarify the Israeli tax treatment of discretionary trusts, i.e. trusts in which distributions are at the discretion of the trustee.
The Circular apparently omits to say that a Relatives’ Trust becomes a fully taxable Israeli Residents’ trust after the death of the settlor and his spouse.
The Amendment treats a Relatives’ Trust as an Israeli Resident, therefore all its worldwide income and gains are taxable in Israel, regardless of overseas beneficiaries. This is a major issue for many multinational families with some family members living in Israel.
The Circular says the ITA will consider giving a solution to this issue pursuant to tax regulations dealing with allocations and distributions
The regulations are complex regulations and the penalty for not distributing income to overseas beneficiaries within a four year cycle can be 70% tax. This aspect of the legislation is unjustifiable in our view.
Capital versus Income:
Distributions on the Distributions Track are exempt from Israeli tax if the trustee can prove that they are capital in nature, not income. However the definition of capital is restricted to assets contributed by the settlor to the trustee which would have been exempt had they been transferred (i.e. gifted) by the settlor to the beneficiary directly. Also, the law assumes income to be distributed first, before capital.
How does the trustee prove that distributions are capital in nature? The Circular says that trustees are “entitled” to register for Israeli tax purposes and file annual tax returns.
The Circular does not discuss trust accounting requirements. In practice, trustees would be well-advised to maintain a sound transparent accounting system that conforms to Israeli rules regarding capital, translation to Shekels, expenses deductions, overhead allocations, distributions, taxes, and so forth.
The Circular contains a complex discussion of the rules and transitional provisions in the Amendment relating to new residents and senior returning residents (who lived abroad 10 years).
In general, new and senior returning residents may enjoy a ten year tax holiday from Israeli tax on overseas income and gains if they became resident on or after January 1, 2007.
Returning residents who lived abroad 6 – 9.9 years may enjoy a 5 year tax holiday for overseas passive income handled via a dedicated bank account.
In the trust context, some of the Aliya tax breaks for overseas income were restricted in the Amendment.
- In the case of an Israeli Residents’ Trust (with an Israeli resident settlor) which became so because a settlor made Aliya before August 1, 2013 OR was formed before that date by an Oleh when he was in his tax holiday: no Israeli tax nor tax reporting is apparently due from the trust so long as the settlor is alive and in his tax holiday;
- In the case of an Israeli Residents’ Trust which became so because a settlor made Aliya after August 1, 2013 OR was formed after that date by an Oleh when he was in his tax holiday: no Israeli tax nor tax reporting is apparently due from the trust, so long as the settlor and all the beneficiaries are in their tax holiday (or are foreign residents);
- Beneficiaries of an Israeli Residents’ Trust need not report distributions received out of overseas income so long as they are in a ten year tax holiday (or are foreign residents);
- Beneficiaries of a Relatives’ Trust (with a foreign resident settlor), need not report distributions or allocations of overseas income so long as they are in their tax holiday (or are foreign residents or Israeli charities).
What Else is Missing in the Circular?
It is regrettable that the Circular does not discuss: foreign tax credits, the treatment of US grantor trusts, tax treaty provision and the interaction with amnesty procedures.
To Sum Up:
The Circular attempts to paper over some major cracks in the Amendment regarding trusts, in particular regarding overseas beneficiaries, discretionary trusts and foreign tax credits. The result is more uncertainty. Trustees should start keeping accounts in Shekels that meet Israeli tax requirements, otherwise unnecessary tax may be paid
As always, consult experienced tax advisors in each country at an early stage in specific cases.
The writer is a certified public accountant and tax specialist at Harris Consulting & Tax Ltd.